Small-cap action is good for the market

Kevin Marder is a guest columnist and a co-founder of MarketWatch. He is
principal of Marder Investment Advisors Corp. and a contributor to
The Gilmo
Report. Previously, he served as chief market strategist for Ladenburg Thalmann
Co. and developed institutional fixed-income risk management software for
Capital Management Sciences.

At first glance, the three-month rally in shares appears to be dying on the vine, with volume below average for six days running. Each of the last three sessions has seen price rise or fall by just 0.1%.

A look at the small-capitalization Russell 2000 (IWM) index tells a slightly different story. There, the index is up 19.1% over the past three months vs. the 12.3% rise of the S&P. The past few sessions have seen the R2K up 0.4% on days in which the S&P rises 0.1%.

Small-capitalization outperformance for a few months is not what is normally seen at the end of a bull market. It is usually witnessed in the early stage of a bull. Ditto for interest-sensitive groups like the brokers (XBD), up about 35% since the move began three months ago, and swamping the showings of the S&P and R2K. Banks, meanwhile, price in a steeper yield curve some months out.

One advance indicator of a primary bull market top would be a divergence between the broader market and the averages. Small-capitalization issues would serve as a proxy for the average stock. Seeing the Dow Jones Industrials and S&P make new highs that are unconfirmed by new highs in the R2K would be evidence of subsurface weakening.

Because every bull market is different, there is not an exact timeline between the onset of a top in the broader market and the ultimate bull market top in the blue-chip indices. It can sometimes be six months or less, while other times it can be more than a year.

At the end of the '90s bubble era, the average stock topped more than two years ahead of the Industrials and S&P. So this can be a very rough — too rough, sometimes — gauge of an eventual top. Worth watching, in any case.

A recent report discussed the possibility of a speculator's portfolios of glamours being subjected to two or three spinouts during earnings season. There is no rule that says it is always two or three. Three may have been the most that ever occurred to this participant in one earnings season. Two might be an average when holding a good number of names in a portfolio, say 15.

Rackspace Hosting
US:RAX
was one such spinout on Wednesday, down 19.6% after an earnings report that included a revenue miss. In the below chart, three gray vertical lines highlight major distribution days (large-investor selling) that occurred in the 11 sessions prior to the earnings release.

While big-money flows into or out of a stock in the sessions preceding a report can sometimes be a harbinger of the report itself, this cannot be counted on. Besides hedging through the use of an option, the only real defense against earnings downdrafts is to reduce the position size ahead of the report.

Invensense
US:INVN
was mentioned here Tuesday ("Aggressive speculators can consider entering on a takeout of this level, with a standard stop loss of 5%-7% below entry."). Later that day, the stock broke out on volume 330% above normal, but sellers entered the picture and on Wednesday drove the stock below the 5%-7% stop loss level.

Pharmacyclics
US:PCYC
was mentioned in the Feb. 5 report. ("The Jan. 28 high of 71.91 represents another potential entry pivot."). Wednesday, the stock broke out of a five-month base to gain 9.5% on volume 166% above average.

While the company first went profitable on an annual basis in the June 2012 year, and is expected by most analysts to record 137% earnings growth in the June 2013 year, most estimates call for a loss in 2014.

The attraction here was twofold: 1) the high relative price strength, as the stock is up over 600% in the last 14 months, and 2) the base is long and constructive, including the gnarly early-November shakeout and the dimming volume over the past two months.

Database software developer Splunk
SPLK, -1.34%
a recent new issue, was noted in the Jan. 29 report ("Should the stock not exceed Monday's high of 34.98 for at least a few days, that high could be used by an aggressive speculator as a potential entry pivot."). Since then, price has not eclipsed the 34.98 high of Jan. 28. Ergo, this level stands as a potential pivot for an aggressive operator.

While the company has yet to turn an annual profit, it is expected to do so in the January 2014 fiscal year. Meanwhile, revenue grew 71% and 67% in the past two quarters, respectively, and sequential quarterly revenue growth was 20% and 17% over the same period.

Perhaps most impressive is the company's opening-day performance nearly 10 months ago, a double. Today it sells at about the same price.

Elsewhere, Walter Investment Management
WAC, -9.85%
looks interesting above the Jan. 8 high of 49.67. AMC Networks
AMCX, -0.67%
appears potentially buyable using the Jan. 25 high of 60.95 as a cheater entrance. Zillow
Z, -0.23%
has a lot more work to do to be taken seriously, yet is up 81% in three months as participants find it hard to ignore the major earnings growth estimates for '13/'14.

In summation, the price/volume behavior of the averages is positive and the action of leading stocks is constructive. The intermediate-term speculator has a number of growth and some cyclical titles to sink her teeth into. The risk is a budget showdown later this month, and the potential for forced spending cuts that would pressure growth.

The views contained herein represent those of Marder Investment Advisors Corp. ("MIAC"). At the time of this writing, of the stocks mentioned in this report, Kevin Marder, MIAC, or an affiliate thereof held no positions, though positions are subject to change at any time and without notice. This information, which may have been previously disseminated, is issued solely for informational and educational purposes and does not constitute an offer to sell or a solicitation of an offer to buy securities. The information contained herein is based on sources which we believe to be reliable but is not guaranteed by us as being accurate and does not purport to be a complete statement or summary of available data. Past performance of any security or strategy is not a guarantee, nor is it necessarily indicative, of future results. Opinions expressed herein are statements of our judgment as of the publication date and are subject to change without notice. Entities including but not limited to MIAC, its members, officers, directors, employees, customers, agents, and affiliates may have a position, long or short, in the securities referred to herein, and/or other related securities, and may increase or decrease such position or take a contra position.

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